Tuesday, April 2, 2013

Converting Swaps into Futures

This article appeared in The Edge, Malaysia on September 10, 2012

“Regulators win as ICE converts swaps to futures” – read the Thompson Reuters Westlaw’s headline on Aug 6. The Intercontinental Exchange (ICE) had announced that all its over-the-counter (OTC)  cleared energy swaps would be converted to futures contracts from January 2013.
A “cleared swap” is a term introduced in 2009 as part of an effort to standardise the OTC derivatives in order to bring them on to exchanges, and be subjected to mark-to-market and margining rules.  Cleared swaps are swaps that are traded and settled with the exchanges. Hence, when a party enters a cleared swap, the other side of the trade is the Exchange.
Once a standardised swap trades on the exchange, they quite resemble futures. In this article, I show how a swap can be converted into futures. The trade is chosen from one of the trades published by the CFTC (the U.S. Commodity Futures Trading Commission) in the U.S. Federal Register in Nov 2010.
The Swap
We have a fixed for floating WTI (West Texas Intermediate) Crude Oil swap with features shown in Table 1. This swap will have cash flows as shown in Chart 1, with Party A paying a fixed rate of $80 per barrel for 100,000 barrels every month and receiving the floating rate for 100,000 barrels each month. The floating rate is the settlement rate of the one-month futures expiring on the 22nd of the preceding month.
Table 1